Risky Business

by Drew DeSilver

Public pension plans around the country are under fire for being overly generous and underfunded. But in Oregon, the real issue may be how they’re handling their investments.

Public-sector pensions are having a rough time of it these days. Their investment returns were gutted by the 2008–09 financial collapse and have yet to fully recover. Government officials fear their budget-busting potential. And taxpayers wonder why government workers should get guaranteed lifetime retirement benefits, especially when those benefits are based on deals cut long ago in rosier economic times.

Nearly all states have either increased the amounts employees must contribute to their plans or are considering doing so. States also are raising age and length-of-service requirements, limiting or repealing automatic cost-ofliving increases for retirees, and cracking down on such notorious practices as “double dipping (collecting pension benefits from one government job while working at another) and “salary spiking” (using overtime, untaken vacation and other tricks to boost one’s salary in the last few years before retirement, which most plans use to calculate benefits).

But until recently, relatively little attention has been paid to the asset side of the pension puzzle: the stocks, bonds, office buildings and investments that are supposed to pay for the promised benefits. While some academics and think tanks question whether plans are assuming overly optimistic investment returns, few have scrutinized the investment choices themselves.

Enter Jason Seibert JD’09.

Earlier this year, Seibert, on behalf of two state workers, sued the Oregon Investment Council (OIC), the directors of Oregon’s Public Employees Retirement System (PERS), State Treasurer Ted Wheeler, the attorney general’s office and a host of other people responsible for managing or overseeing the state’s $60 billion pension fund. Seibert’s main allegation: The OIC breached its fiduciary duties in 2008 and 2010 when it agreed to invest $1 billion with Lone Star Funds, one of its favored money managers, to buy distressed real-estate debt. Lone Star also is named in the suit.

The Oregon attorney general has rejected a call to appoint an independent special counsel to investigate the Lone Star investments, choosing instead to represent all the defendants. As of press time, the defendants hadn’t formally responded to the suit.

The lawsuit cites several reasons in support of its allegation that the Lone Star deal was imprudent. Perhaps the most sensational accusation involves a securities manipulation case against Lone Star and its officers in South Korea; the suit claims that Lone Star failed to fully inform the OIC about the case and that Oregon decisionmakers dismissed it as irrelevant when they learned the full story.

At its core, though, Seibert’s suit challenges the way the OIC and state treasurer manage the money state workers depend on to support them in retirement. The Lone Star funds are one slice of the pension plan’s $18.5 billion bet on “alternative” investments, which includes private equity, hedge funds and real estate. Close to a third of PERS’ pension assets are invested in alternatives; private equity alone accounts for nearly 21 percent. A recent survey of large public pensions by research firm Preqin ranked Oregon’s fund third-highest in its share of its investments in private equity, trailing only Washington state and Pennsylvania.

Across the nation, public pensions are shifting money out of stocks — whose returns in recent years have been paltry at best — and into alternatives that often are far more risky. A survey last year by the trade publication Pensions & Investments found 92 percent of large public and private pension plans were invested in private equity. Sixty percent were in hedge funds.

Seibert and his former law school professor, Meyer Eisenberg, argue that private equity and similar investments are highly speculative, difficult or virtually impossible to value accurately and often require investors to lock up their money for years. All that, they say, means pensions must tread carefully when making alternative investments — much more carefully than PERS has.

“Maybe 5 percent or even 10 percent might still be prudent, but not 30 or 40 percent,” says Eisenberg, a former deputy general counsel for the Securities and Exchange Commission. “Can pension managers take some chances? Sure, but not like that.”

All defined benefit plans — those that pay a set monthly benefit based on some combination of service length and final salary — face the same challenge: how to make today’s assets pay benefits for decades to come. The more plans can earn from stocks, bonds, real estate speculation, foreign currency and other investments, the less they’ll have to collect from cash-strapped local governments and their employees.

In order to determine whether they have enough money to pay out their promised benefits, pension funds must assume a certain long-term rate of return. Oregon’s assumed rate is 8 percent, which is about what most plans have been able to deliver by investing in a mix of common stocks and bonds.

However, the overall stock market has been mostly flat ever since the dot-com crash of 2000 and substantially more volatile since the 2008 economic meltdown. Bond returns are down, too. Consequently, several pension funds have lowered their assumed rates of return, and Treasurer Wheeler recently suggested that the PERS board do the same. But that creates a problem: A lower assumed return rate means workers and local governments must contribute more money.

One response is to invest beyond the stock and bond markets, says William “Flick” Fornia, a veteran retirement consultant and actuary in Denver who specializes in public pension funds. Alternative investments such as private equity and hedge funds may be riskier, but they offer higher returns.

“It’s harder to get good returns without looking at investments the average person can’t access,” Fornia says. Pensions, he adds, “have got the experience and they’ve got the [long] time horizons, so it makes sense to take the risk.”

But assigning a value to private equity investments, which typically last many years and have no real “market price” until they’re finally sold, is tricky. The “fair value” numbers on PERS’ investment books come from the fund managers, who see what comparable companies are selling for, project future profits and discount them back to today, or employ other valuation methods — all of which depend heavily on the assumptions and choices made by the managers or their advisors.

Investors in private equity, hedge funds and other alternative investments typically don’t know going in what the fund manager will do with their money. Nor do investors usually have access to all the data needed to check valuations of the assets. That means they have to rely mainly on the fund managers’ reputation and track record in deciding whether to commit cash.

In the case of PERS, Seibert says, “people got into the habit of approving these funds” without looking too closely at them. Their attitude, he added, seemed to be, “Who cares how we get the returns so long as we get the returns?”

In the Lone Star case, Seibert and Eisenberg say, that reliance went beyond prudence. Lone Star should have been suspect because it was enmeshed in the South Korean securities case at the same time it was pitching the OIC on its newest funds. In addition, they say, those funds were effectively “blind pools,” with little known about them other than that they would invest in distressed debt.

And, he added, given that the Lone Star funds purchased billions of dollars worth of “toxic” collateralized debt obligations — financial instruments comprised of bits and pieces of other securities — it’s almost impossible to tell if they’re really worth what Lone Star says they are.

For decades, state laws strictly limited the kinds of investments that public pension managers could make. Oregon was one of the first states to loosen its investment rules, in the mid-1960s, when lawmakers allowed PERS to buy stocks. Today, Oregon’s only statutory restriction on public pension investments is that no more than half of the pension fund can be invested in stocks.

In the 1980s, PERS began investing in private equity and hedge funds. Hedge funds employ a broad range of investment strategies, including trading in options, commodity futures, foreign-currency swaps, and other exotic securities. Private equity firms focus on one of two strategies: Venture capitalists invest in young, cutting-edge companies, while buyout firms seek to take control of publicly traded but underperforming companies, retool them and then resell them at a profit (often after extracting cash profits in the form of dividends).

A $194.1 million investment with leveraged buyout firm Kohlberg Kravis Roberts in 1981 made PERS one of the first public pension funds in the nation to experiment with private equity. As the 1990s began, PERS began spreading its private equity dollars more widely and increased the total amount invested.

As of the end of the 2011 fiscal year, PERS had $12.8 billion, or 20.9 percent, of its assets in private equity. Another $5.7 billion, or 9.3 percent, was invested in real estate ventures. (By contrast, the average asset mix among the 200 largest public pension funds last year included just 10.5 percent in private equity and 7.2 percent in real estate).

According to PERS data, since its initial 1981 investment the fund has gotten back more than one-and-a-half times the $26.8 billion it has plowed into private equity. As of fiscal year 2011, private equity had a 5-year average annual return of 9.4 percent, the highest in the fund.

Those returns have helped PERS recover somewhat from the financial panic of 2008–09, though the fund is still below its pre-crash level. PERS says the system’s benefit obligations were 86.7 percent funded as of the end of 2010; a study by the Pew Center on the States found that only seven state plans were better funded.

A recent study found that buyout funds have outperformed the Standard & Poor’s 500 stock index for most of the past three decades. Each dollar invested in the average private equity fund, the study estimated, returned at least 20 percent more than a dollar invested in the S&P.

But those return calculations assume that the funds’ investments are fairly and accurately valued. Should the assets end up being worth less than their value on the plans’ books, the plans will be short of money they were counting on to pay benefits — meaning either more benefit cuts or more cash pumped in by local governments.

Private equity has another feature that perhaps ought to give pension funds pause: While its returns still beat the stock market, they’ve been trending lower over time. Also, several researchers have identified a seeming paradox: The more money that investors pour into private equity funds, the lower their returns are. One theory is that when funds were few and small, they could more easily find promising startups and undervalued companies; now the low-hanging fruit is gone, and funds are competing intensely against one another to find the best deals.

Oregon’s PERS isn’t likely to turn its back on alternative financing anytime soon. As of June this year it had committed $250.4 million to private equity. And in December 2011, PERS invested $100 million in a “catastrophe fund” that invests in insurers’ risk from hurricanes, earthquakes and other natural disasters.

Catastrophe investments can produce ample returns so long as the skies remain clear and the ground solid, but the potential downside is sobering: A $300 million catastrophe bond was among the casualties of the March 2011 Japanese earthquake.